Understanding Loan Terms and Interest Rates
The kind of mortgage you choose has a big impact on how much you end up paying for your new home — how much you’ll have to pay upfront, your monthly payment amount, and the total cost of your loan over time. It also affects the level of risk you take on. Knowing what kind of loan is most appropriate for your situation prepares you for talking to lenders and choosing the best option for you.
Your ideal mortgage will depend on your own individual financial situation and goals. Take time now to explore your options and think about what kind of mortgage loan is right for you. You’ll be more confident in the process and have fewer surprises down the road.
Begin by understanding your options and how different kinds of mortgages work: A loan “option” is always made up of three different things — the Loan Term, the Interest Rate Type, and the Loan Type.
The term of your loan is how long you have to repay the loan — 30-year and 15-year mortgages are most common, but there are plenty of other options, including 10-year, 20-year, 25-year, and even 40-year terms.
Your choice of loan term affects your monthly principal and interest payment, your interest rate, and how much interest you’ll pay over the life of the loan. In general, the longer your loan term, the more interest you’ll pay. Loans with shorter terms (15 years, for example) usually have lower interest costs but higher monthly payments than loans with longer terms.
Interest Rate Type
Interest rates come in two basic types: fixed and adjustable. The choice affects whether your interest rate can change, whether your monthly principal and interest payment can change (and by how much), and how much interest you will pay over the life of the loan.
• Fixed Rate Mortgage
A fixed-rate mortgage is exactly what it sounds like: A mortgage with a fixed interest rate. With a fixed-rate mortgage, your interest rate is locked for the life of the mortgage loan and cannot change. When interest rates are at historical lows, a fixed-rate mortgage is an ideal financing option. By purchasing a fixed-rate mortgage at a low interest rate, buyers lock in low payments and are protected from periodic rate increases.
Keep in mind that with a fixed-rate loan, your interest rate and monthly principal and interest payment will stay the same, however your total monthly payment can still change if your property taxes, homeowner’s insurance, or mortgage insurance goes up or down.
• Adjustable Rate Mortgage
An adjustable-rate mortgage (ARM) is a mortgage where the interest rate fluctuates over time. Typically, the interest rate will stay constant during a set period of time near the start of the mortgage, and then start to adjust. The rates rise and fall in line with the prime lending rate. The advantage of an adjustable rate mortgage is that it offers lower initial rates and payments. However, ARMs can quickly become expensive if interest rates see a sharp rise.
Most ARMs have two periods. During the first period, your interest rate is fixed and won’t change. During the second period, your rate goes up and down regularly based on market changes. ARMs tend to be riskier for the borrower, so it’s important to understand how your rate is calculated and how much, and how often, your rate and payment can adjust.
Mortgage loans are organized into categories based on the size of the loan and whether they are part of a government program. This choice affects how much you will need for a down payment, the total cost of your loan (including interest and mortgage insurance), how much you can borrow, and the house price range you can consider. For types of home loans, click here.